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Venture Capitalism: When Old and New Collide


Buzzwords like crowdfunding, disruptive technology, angel investing, and the latest funding category to enter: entrepreneurial investing; have all aided in the attraction to the hotbed topic of venture capitalism. It would appear to the keen observer that private equity – a relative of venture capital – has spurred new attention. Perform any casual browser search and what will show up are descriptions such as “cool” and “sexy” to characterize what being in the VC industry must be like; as though it were a handsome and suave cadet and private equity was Cyrano de Bergerac.

With so much press in general about venture capital and, thusly, those who run them, such as Ben Horowitz and Marc Andreessen of Andreessen Horowitz, Reid Hoffman of Greylock Partners, serial entrepreneur Max Levchin, and long-time investor John Doerr of Kleiner Perkins, that I have decided to form my own take on the matter. But rather than spending most of the time on various individuals, I will instead do a broader view of the industry and where I see it going moving forward.

Since late-1990s becoming a venture capitalist has grown in popularity and has now reached iconic status. Within a span of two decades fandom has spread to unimagined heights,  that even celebrities such as Ashton Kutcher has gotten in on the act partnering with others to form the venture capital company A-Grade Investments.  As a result of the magnitude of venture capitalism, Kutcher and Justin Bieber (yes, “the biebs”) now represent a growing example of tech-savvy celebrities using their fame to secure stakes in [a range of] Silicon Valley darlings.

Fame and infamy aside, the aftermath of the dotcom disaster left many investors with a bitter taste.  It has taken years for many funds to recover from the loss from the Internet bust (’00) and the financial flop (’07).  Despite investors unease limited partners (LP) continued to heavily invest. When comparing total capital invested, $1,392B from 2007-2009 against $1,574B from 2010-2013, LPs didn’t skip a beat- they in fact increased distribution; while the funds raised by LPs decreased, from 2007-2009,$573B, to 2010-2013, $402B.  Numbers taken from the Private Equity Growth Capital Council.

Regardless of the residual effects from the tech and credit busts, the majority of VC-backed companies are finance and IT-related because of the high returns expected from a VC portfolio company.  Although, it is shown that the success rate of a new venture-backed company is low. So, with the aforementioned facts in mind, I gather success is measured depending on which end of the yardstick you are looking at.

Old Versus New
The industry may be mostly driven by high-tech firms but it is fueled by the shift from old to new methodologies of valuation and intensified by competing for large returns.  Under the old practice, years of experience and reliance on gut instincts were touted by fund managers.  The new (within the past five years) method, on the other hand, uses computer-based models for predicting outcomes. Yet, Marc Andreessen, a software engineer, recently declared in a Twitter feed when valuating both public and private tech companies that “spreadsheet investing is often disastrous.”

In a 2010 report it was noted that PIMCO, the world’s largest bond fund, first used the phrase the ‘new normal’ back in 2009 as a way to describe a low-rate, low-return environment that they expect to persist for a considerable period. It went on to explain, “A new venture ecosystem characterized by ‘capital efficient’ funds which rose a modest amount of capital and can deliver good returns to their investors with $50M ‘quick flip exits’. This approach is favored by LPs who invest in venture funds.”

At the time, institutional money managers were moderately investing with venture funds. Not a lot of capital was needed to fund these tech companies in part because it was cheap to do so, and with no way of knowing its worth before testing, many accepted whatever was offered.  However, as time progressed, fund managers began to take on the notion of the more capital invested, the higher the reward.  This practice may work in theory but when the asset class isn’t taken into consideration it can make for dreadful results.

What’s it Worth to Ya?!
As in anything, you won’t know the real worth of something until someone else tell you its value.

Chris DeVore, a Seattle-based investor, posted on the basic mechanics of venture finance and stated “real” investor value comes, essentially, post-IPO or M&A activity.  He went on to say value creation, or capital efficiency, is generated not solely on the total amount of capital raised by the startup but instead on “total capital raised over the life of the company and total value created over the life of the company.”  Value, therefore, is only manifested after the sell. It is in the exit of venture funding where those involved (VCs, LPs & investors) make their money.

Venture capitalists determine value by way of terminal value. Value that is placed on the product(s) and/or the company itself in order to reflect its worth in the near future – typically ten years out – along with the investment strategy or stage of the VC and risk. Keeping in mind, as indicated by the National Venture Capital Association, that its goal “is to grow the company to a point where it can go public, [merge] or be acquired by a larger corporation at a price that far exceeds the amount of capital invested.”

Last year, the top 15 exits by value creation reached nearly $19 billion with total financing of $471.5 million raised, according to database research firm, CB Insights. “Cloud-based life sciences software firm Veeva Systems tops the list of venture-backed exits by value creation, netting a valuation of over $4B in its IPO on just $4M of financing from Emergence Capital Partners;” a value creation ratio of 1100%.

Interestingly, total tech IPO fell 7% in 2013 on a year-over-year basis, despite the top 10 largest VC exits coming from high-profile tech offerings by Twitter, Zulily and Veeva Systems. Yahoo’s $1.1B acquisition of Tumblr, marks the only M&A exit to make the top 10 – and was just one of three disclosed venture-backed acquisitions valued at over $1B in 2013.  Additionally, 52% of all U.S. venture-backed IPOs last year were healthcare firms.

For Q1 2014, $9.47B has been invested in 951 deals with $9.96M funded for each deal. Out of the 951 deals, 414 were in software (42.34%) or $440.9M. The second-most invested industry is biotech with 112 deals (11.22%) or $106.2M and third, IT services with 59 deals (8.62%) or $816M. Data published from the MoneyTree Report.

“All the World’s a Stage”
Each stage has its own level of financing. Instead of VCs funding a company all at once financing is determined at appointed rounds. If the company has successfully met the requirements then the next round of funding begins.

The stage level, or round, consists of:
• (Seed); Round
• Early-stage/Startup; (Series A Round)
• Growth-Stage/Expansion; (Series B Round)
• Late-stage; (Series C Round)
For a complete definition see, http://www.wisegeek.org/what-is-venture-capital.htm

Is it a wave or natural progression?
John Doerr once referenced to innovation being on its third wave of social, mobile and new commerce in 2010 but Om Malik, venture capitalist, founder of Gigaom and former journalist, said it is instead a natural evolution of the Internet. A Kauffman journal (2010) supports Malik’s assessment and through the use of venture capital – as a driver of innovation – based from the principle of market forces concluded that venture activity is cyclical.

The authors’ findings showed that returns – internal rate of return – have trended downward for more than a decade. “The rolling 10-year IRR for the venture capital industry as a whole has been trending below 10%, much lower than the 20%+ IRR that is typically demanded from venture investments.”  The current US venture capital 10-year return, or benchmark, is 8.58%

Proceeds from exits have also dipped from the $650 billion level in the 1990s to $354 billion in 2010, while capital invested almost doubled from $338 billion to $597 billion, according to the authors.  As more money is pumped into a fund early on it tends to depress IRR – negating a long-term investment strategy.

Today’s figures, from the same MoneyTree report, point to seed-stage investing falling 26% in deals in 2013 with $943M going to 218 companies, the lowest number of seed deals since 2003, but increased 14% in terms of dollars. On the other hand, early-stage investments jumped 17% in dollars and in deals by 15% with $9.8 billion going into 2,003 deals for 2013.  The number of expansion deals remained unchanged for the year at 984 but advanced 4% in the dollar amount to $9.8B. For later stage deals a 1% increase in dollars to $8.8B with a 6% decrease in the number of deals to 790.

Is it a Dream or Dose of Reality?
• More VC-backed new companies – three out of four – fail to succeed.
• Size of active funds (191 deals) in 2013 decreased from $19.7B (211 deals) the previous year to $16.9B.
• U.S. ranks 20 – out of 189 different economies – in the ease of starting a business, down 9 points from 2013.
• Number of small business loans approved in March from large banks is up nearly 20% from last year.
• Since 2010 entrepreneurial activity has dipped by.02% per year with .28% reflected for 2013.  However, “The decline in business creation may be due to improving economic conditions;” startups arenot being created out of necessity.

Back to Basics
PIMCO’s CEO Bill Gross announced to investors this month, “Expectations for returns for all unleveraged assets and diversified portfolios that attempt to reduce risk and maximize return will be in the low- to mid-single digits.” In other words, the new normal of 2009 is dissipating.

A signal has arrived but not in the form many investors were hoping. How does PIMCO’s projection of US economic growth impact venture capital activity? As economic expansion, hopefully, occurs there will be less pressure on LPs looking for safer investment alternatives which will in turn create less demand on venture capitalists to pick up the pace of startups reaching maturity. As we have witnessed, the higher and faster that tech IPO valuations accelerated, so did the capital invested; which explains for the past two years why there has been a lot of tech IPOs, so the exits will catch up to the capital invested. While having a fast exit plan, usually four to six years after the initial investment, is nothing new, the funds presently active aren’t positioned for this any longer.

This is the actual market correction that is taking place. The venture capital industry is beginning its next cyclical phase. As it progresses, VCs will continue in its ultimate search for the next Steve Jobs, Bill Gates or Sergey Brin. In the meanwhile, as venture capitalists mull over their portfolio pursuing diversification, the industry could go through its own form of change. Perhaps that change could come not in the manner of what is being invested but who is doing the investing. I know it’s not a simple objective because VC partners typically have teams made up of similar professional experience, academic background and vocational outlook, but you never know, the next Steve Jobs or Bill Gates could appear not as expected either.


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